I’m Not Understanding Why This is a Question

I’m Not Understanding Why This is a Question

      In a December, 2018 ruling, the Federal District Court in South Dakota referred a trio of questions to the South Dakota Supreme Court, all dealing with limited liability company law. As of yet, it does not appear that the South Dakota Supreme Court has taken any action or issued any ruling as to whether or not it will answer the referred questions. SDIF Limited Partnership 2 v. Tentexkota, LLC, 1:17-cv-01002-CBK, 2018 WL 6493160 (D. S.D. Dec. 10, 2018).

      First the background. SDIF made two loans to Tentexkota totaling $32.5 million, which funds were to be used to develop a casino and resort in Deadwood, South Dakota. The funds that were loaned had been generated through investments from individual foreign investors seeking to participate in the EB-5 Lawful Permanent Resident Visa Program. Under that program, it is required that the loans be guaranteed by the members of the borrower organization. When the loan went into default, SDIF sought to collect on those guarantees.

       As recounted by the court, Tentexkota’s articles of organization contained a provision that the members were not liable for the debts and obligations of the company, citing section 47-34A-303(c) of the South Dakota LLC Act. That provision provides that some or all of the members of an LLC may agree to be liable for all or specified debts or obligations of the LLC if “(1) A provision to that effect is contained in the articles of organization; and (2) A member so libel has consented in writing to the adoption of the provision or to be bound by the provision.” It may be important to the case that the articles, rather than reciting that the members may become liable as contemplated by this provision, provides rather, inter alia, that no election into that provision has been made. The operating agreement as well provided that there could be mandatory capital calls and that “The Members may also be required by the vote of the Majority to personally guarantee the obligations of the Company.” The district court noted there is no evidence of any such vote had taken place.

      In addition, the court referenced South Dakota § 53-9-1, which provides “a contract provision contrary to an express provision of law or to the policy of express loss, though not expressly prohibited or otherwise contrary to good morals, is unlawful.”

      The guarantee documents provided that they were executed by “[name of guarantor], as member of Borrower.” Another decision rendered the same day as that cited above indicates that the member capacity may be the core issue:

The parties do not dispute that there is no controlling precedent in South Dakota determining whether DSCL 47-34A-303 would invalidate personal guarantees signed by members of an LLC in their capacity as members where the LLC has not amended its articles of organization to provide for this outcome and the members have not otherwise consented in writing to the adoption of such a provision.

            SDIF Limited Partnership 2 v. Tentexkota, LLC, 1:17-CV-01002-CBK, 2018 WL 6486467, *3 (D. S.D. Dec. 10, 2018) (emphasis added).

      With that background, three questions were tendered to the South Dakota Supreme Court, namely:

·         does the provision of the South Dakota LLC Act affording members limited liability invalidate the personal guarantees signed by the LLCs members in their capacity as members where the LLC’s articles do not provide that the members are liable for its debts and obligations in their member capacities and the members have not consented in writing to be so bound [inter alia, adopting South Dakota § 47-34A-303(c)];

·         if the guarantees violate the LLC Act, does South Dakota § 53-9-1 prohibit recovery under the guarantees; and

·         “what is the legal effect of the LLC’s operating agreement permitting members to personally guarantee corporate debts but only by a “vote” of the majority of members when there is no evidence of any such “vote”?

      I am confused as to why any of this is in dispute. A provision such as subsection (c) of the otherwise applicable rule of limited liability exist so that members may, ab initio, waive their limited liability. This faculty is typically employed in highly lawyered transactions where, for example, limited liability needs to be waived in order to avoid the application of section 469 of the Internal Revenue Code in connection with oil and gas deals and the pass-through deduction for intangible drilling costs. Other times it is employed to avoid the need for contractual guarantees by providing, ab initio, that the members, all or some, are as well obligors on the debt. In still another application, an election to accept responsibility for an LLC obligation would, as to that member, convert the obligation from nonrecourse to recourse with attendant impact upon the ability to claim basis. This suit is, to my knowledge, the first time that someone has asserted that language of this nature protects a guarantor from enforcement of a guarantee.

      More broadly, a guarantee is a bilateral contract between the lender and the guarantor pursuant to which the guarantor provides credit enhancement with respect to the debtor's obligation. As such a guarantee is not part of the LLC’s operating agreement, which is the agreement of all of the members with respect to the management and affairs of the LLC. The borrower is typically not a party to the guarantee agreement.

      Ultimately, I cannot imagine how the limited liability provision of the LLC Act is implicated in the dispute between the lenders and the guarantors. Admittedly, it is unfortunate that the guarantors provided their signatures “as members of” the LLC.

      Regardless, we wait and see whether the South Dakota Supreme Court will accept the question and provide answers.

As Amended From Time to Time

As Amended From Time to Time

As Amended From Time to Time is my most recent column from the Journal of Passthrough Entities.

 

       This article considers the impact of an amendment to an LLC Act when the operating agreement of a particular LLC does not address the issue. Essentially, does the LLC Act as it existed at the time the operating agreement was adopted continue to control, or in the alternative are the LLC and its members now bound by the LLC Act as amended?

 

      This is a complicated question of statutory interpretation that may be impacted by the wording of any particular operating agreement. For those reasons, I cannot give a definitive answer one way or the other. I submit, however, that the most important issue is to be aware of the question.

 

      HERE IS A LINK to the article.

Your Ways Are Not Our Ways

Your Ways Are Not Our Ways

“Your ways are not our ways” are words said by Dracula in the movie Bram Stoker’s Dracula; Transylvania and Victorian London being rather dissimilar.  They apply as well today when assessing the law of other states; different states can have entirely different, but each equally legitimate, rules.  This principle applies when assessing a recent decision out of New York and considering if the same result would happen in Kentucky.

Peter Mahler, in his excellent New York Business Divorce blog, recently reviewed a New York decision on minority shareholder oppression, Matter of Digeser v. Flach, 2015 NY Slip Op 51609(U), a case in which the heirs of the founders of a pair of companies had a falling out.  The minority shareholder found his management position and employment in the corporations terminated, and brought suit seeking judicial dissolution on the basis of oppression.  Flach, the majority shareholder, also terminated the employment of Digeser’s sons and engaged in a variety of other actions that Digeser asserted were oppressive.  Ultimately both the trial court and the court of appeals would determine that oppression had taken place, allowing the action for judicial dissolution of the corporations to proceed. Peter excellent review of the case, through which the decision itself can be assessed, is available AT THIS LINK.

But is this good law in Kentucky?  Probably not.  The New York law governing corporations includes, at § 1104-a(1), “oppression” as a basis for seeking judicial dissolution.  Kentucky, at KRS § 271B.14-300(2)(b) does not include oppression as a basis for dissolution.  In fact, when this provision was drafted, the MBCA included “oppression” as a basis for dissolution; that term was removed from the final Kentucky act.  While no Kentucky court has yet addressed the matter, it would seem that whether or not particular conduct is “oppressive” as to the rights of a minority shareholder is a pointless determination; even in the face of oppression there is no statutory basis for judicial dissolution.

Court of Appeals Disposes of Derivative Claims Brought on Individual Basis

Court of Appeals Disposes of Derivative Claims Brought on Individual Basis

      In an August 14 decision, the Kentucky Court of Appeals dismissed, under the rubric of lack of standing, a series of what were determined to be derivative claims that had been brought individually by a shareholder. Ultimately, the court determined that the shareholder lacked standing to bring claims based upon fiduciary duties that, to the extent they existed, were owed to the business organization and not the individual investor. Griffin v. Jones, No. 2014-CA-000402-MR, 2015 WL 4776300 (Ky. App. Aug. 14, 2015).

      David Griffin invested, at the solicitation of Charles Jones, husband to defendant Sarah Jones, $2,000,000 for a 50% ownership interest in Integrated Computer Solutions, Inc. There followed thereafter a series of investments in additional entities organized and controlled by either Charles or Sarah Jones, that total investment, a combination of loans and equity, coming to approximately $29,000,000. It was alleged, however, that Charles and Sarah Jones, in their control of these various entities, caused them to co-mingle their assets and ultimately transfer them to a LLC, CA Jones Management Group LLC, a company in which Charles Griffin was the sole member. Griffin ultimately brought suit against Sarah (this decision does not discuss any claim made against Charles Jones) alleging:

1.      breach of fiduciary duty owed to him, personally;

2.      fraud by omission;

3.      misappropriation; and

4.      unjust enrichment.

The trial court dismissed all of these claims without explanation, and the Court of Appeals would review them under the assumption that the Circuit Court adopted the reasoning employed by Sarah Jones in her motion to dismiss.

      Foreshadowing the theme of the decision, the Court of Appeals wrote that “a proper ground for dismissing the balance of Griffin’s claims was his lack of standing.” Slip op., at 4.

Breach of Fiduciary Duty

      With respect to the claim for breach of fiduciary duty, Griffin alleged that Sarah Jones, in her capacity as a officer of the corporations in which he invested, owed to him a fiduciary duty. For example, he alleged that:

As Secretary of ICS, Sarah Jones owed fiduciary duties to ICS and its shareholders - including Griffin. It is black letter law that corporate officers owed to the corporation and to its shareholders fundamental duties of care and loyalty… Slip op., at 5.

      Responding to this assertion, the Court of Appeals wrote that “Kentucky law does not support that Sarah owed Griffin fiduciary duties under the facts alleged in his complaint.” Slip op., at 7.

      Rather, the court noted that both the common law and statutory fiduciary obligations imposed upon members of the board of directors and corporate officers run to the benefit of the corporation. In the context of an LLC, court noted that, by statute, the duty of loyalty owed in a limited liability company is to “‘account to…the company.’” Slip op., at 8, n. 1.

      Ultimately, in that any alleged breach of fiduciary duty, if indeed it took place, involved a breach of an obligation owed to the business entity, and not to Griffin individually, he lacked standing to bring those claims.

      Another interesting point raised in this decision is the deference to be afforded a plaintiff’s assertion that a fiduciary duty existed. As recited by the Court of Appeals:

It appears Griffin is arguing the Circuit Court was required to believe Sarah owed him direct fiduciary duty in the contexts he describes above because his complaint alleged that she did, and because factual allegations in a complaint must be taken as true whenever a court considers the propriety of granting a CR 12.02 Motion to Dismiss. Slip op., at 7.

      This assertion was categorically rejected by the Court of Appeals. Rather, the assertion that a legal duty exist is a legal conclusion and therefore “any statements in Griffin’s complaint regarding legal duties Sarah may have owed him under the facts of this case are entitled to no deference whatsoever, the court observing that, “[W]hether a legal duty exist is purely a question of law [.]”, Bartley v. Commonwealth, 400 S.W3d 714, 726 (Ky. 2013) and “It is the duty of courts to declare conclusions, and of the parties to state the facts from which legal conclusions may be drawn.”, Rosser v. City of Russellville, 208 S.W.2d 322, 324 (Ky. 1948).

Fraud by Omission

      Having determined that no fiduciary duty existed for the benefit of Griffin, the court was able to dismiss the fraud by omission claim on the basis that there existed no obligation to make disclosure. “Griffin has premised the first element of his fraud by omission claims, once again, upon the notion that Sarah owed him a direct fiduciary duty of disclosure by virtue of her status as an officer and by virtue of his status as a shareholder, member, or creditor of those entities. As previously discussed, however, she did not.” Slip op., at 11-12 (footnote omitted).

      In addition, the court commented upon Griffin’s implication that the funds invested remained somehow his and that he had a right to be advised as to the disposition of same. Rejecting that notion, the Court of Appeals wrote:

First, he appears to assume that he has a direct interest to assert to a fraud by omission claim because the money he either invested in or loaned to ICS, SEB, and CBR remained his money. But it did not remain his money. Rather, it became an asset of those entities. C. Owens v. C.I.R., 568 F. 2d 1233, 1238 (6th Cir. 1977) (“[S]tock in a corporation represents an ownership interest in a going business organization; the stockholders do not own the corporation’s property.”). Slip op., at 11.

Misappropriation

      With respect to a claim that Jones had misappropriated Griffin’s assets, the court reiterated that the funds allegedly misappropriated belonged to the business organizations and not to Griffin, and as well the fact that, if funds were misappropriated from the corporation, it is to the corporation that any redress is owed.

Unjust Enrichment

      With respect to Griffin’s claim for unjust enrichment against Jones, finding that this claim “Laid bare, this is simply an impermissible attempt to convert a derivative claim into a direct claim to nothing more than an exercise in semantics; it is another way of asserting that Sarah, in her role of corporate officer, indirectly injured him (an investor in shareholder) by misappropriating corporate assets.” Slip op., at 15. This assertion was rejected on the authority of 2815 Grand Realty Corp. v. Goose Creek Energy, Inc., 656 F. Supp.2d 707, 716 (E.D. Ky. 2009), which stands for the proposition that the diminution in the value of stock consequent to an injury to the corporation is a direct injury only to the corporation and, as to a shareholder, is derivative in nature.

      This opinion has been ordered “To Be Published,” and is a welcome addition to (i) the long line of decisions which, inter alia, strictly apply the direct versus derivative distinction in Kentucky law and (ii) those decisions which make clear that the beneficiary of fiduciary duties owed by corporate directors and officers, as well as the duty of loyalty owed in LLCs, as to the business organization itself and not to its constituent investors.

Foreclosure of Missouri LLC Charging Order: Failure to Affirmatively Authorize Treated as No Authorization

Foreclosure of Missouri LLC Charging Order:  Failure to Affirmatively
Authorize Treated as No Authorization

      A recent decision from the Missouri Court of Appeals interpreted the Missouri LLC Act and its charging order provision, concluding that as it did not affirmatively provide for foreclosure, foreclosure is not possible.  DiSalvo Properties, LLC v. BluffView Commercial, LLC, No. ED 101977, 2015 WL 3795402 (Mo. App. June 16, 2015).

      DiSalvo was awarded a default judgment against BluffView.  Seeking to collect thereon, DiSalvo sought and was awarded charging orders against Bluff View’s interests in two other LLCs, Perrydise Properties, LLC and WR Management, LLC. When DiSalvo sought as well a foreclosure sale on those interests he was stymied, the trial court holding that a sheriff’s sale of LLC interests is not available under the charging order provision of the Missouri LLC Act.  It was that determination that would be appealed and ultimately affirmed.

      The Court of Appeals compared the provisions of the Missouri LLC Act’s charging order provision, it not addressing the foreclosure of the lien, with that under the Missouri partnership and limited partnership acts, where foreclosure is addressed and provided for.  The charging order provision of the Missouri partnership act provides for foreclosure of the charging order lien.  While the charging order provision of the Missouri limited partnership act is silent as to foreclosure, the limited partnership act is “linked” to the general partnership act to the effect that if the rule is not set forth in the limited partnership act proper, refer to the general partnership act.  By this mechanism the foreclosure of a charging order against a limited partnership interest is provided for.  In reliance upon that differential, namely that the LLC Act is silent as to foreclosure and does not link to a foreclosure statute, it was held that there is no foreclosure of an LLC charging order.

      As the language in the partnership/limited partnership acts as to foreclosure was in place at the time Missouri adopted its LLC Act:

[W]e presume the 1993 General Assembly legislated with knowledge of those existing laws as explained in Section II.B.1.b., those provisions of the Uniform Partnership Law and Uniform Limited Partnership Law expressly and implicitly authorize a foreclosure and court-ordered sale of charged partnership interests in a general partnership and limited partnership. The legislature could have enacted similar language expressly or implicitly authorizing a foreclosure and court-ordered sale of charged membership interests in an LLC but failed to do so. Given that the legislature was fully aware of the provisions of sections 358.280.2 and 358.060.2 of the Uniform Partnership Law and section 359.671 of the Uniform Limited Partnership Law when enacting the Missouri LLC Act, then under the rule of expressio unius est exclusio alterius, we find the legislature must have intentionally omitted foreclosures and court-ordered sales as a remedy with respect to charged membership interests in an LLC. (citation omitted). 2015 WL 3759402, *4.

 

            The Plaintiff’s argument that an equitable lien is generally subject to foreclosure was rejected on the basis that the specific statutory language controls.

 

            This decision is noteworthy in its determination that the absence of an affirmative grant of a capacity is equivalent to denial of that capacity.  Also, and as this I could be entirely off base, I have understood expressio unius est exclusio alterius to be a rule of construction within a statute but not between statutes.

 

            Professor Carter Bishop, a recognized authority, has critiqued this decision as follows:

 

IMHO, a poorly reasoned opinion by a court more familiar with litigation than business law.

 

A quick scan of my charging order statutes table reveals that nearly all states originally borrowed the limited partnership charging order statute and implanted it in the new LLC Act. Why? The limited partnership was at least an entity with a partial liability shield. At that time, LLPs did not exist so the limited partnership model (foreclosure not directly contemplated) was a more attractive model than the general partnership model (foreclosure permitted). The charging order was not the driving force behind the LLC movement and was more an afterthought.

 

Of course I could be wrong, but I doubt many business entity lawyers had in mind the obscure limited partnership-general partnership backward linkage for cases not covered. In fact, it is perfectly reasonable to argue that the backward LP-to-GP linkage only authorizes foreclosure on the GP interest in a limited partnership but not on the LP interest because GP law does not mention or contemplate a limited partnership in any form. But the law has evolved otherwise and, as the Court properly states, foreclosure is permitted against a general or limited partner interest in a limited partnership.

 

It is naive to suggest that in 1993 the Missouri legislature was aware of this specific LP-GP charging order linkage (Step 1). It is worse to then conclude that by adopting the LP charging order language (silent on foreclosure) the legislature “intended” to preclude foreclosure (Step 2).

 

Why isn’t it preferable to conclude that the legislature never contemplated the subtle LP-GP charging order linkage? If so, by adopting the LP language, the legislature may have “intended” an LLC interest be treated the same as an LP interest - foreclosure permitted. At the very least, this history can be used to create a latent statutory ambiguity to allow the courts to place the burden of proof on the party seeking the charging order that interpretation is more reasonable.

 

Of course, this confusion merits a legislative fix. Indeed, in states that adopt a version of the updated uniform limited partnership act, the old GP linkage is destroyed, the new LP act is completely self-contained, and foreclosure is authorized.

 

In the meantime, if I was forced to decide this issue, the preferred statutory interpretation would be that by adopting the LP language, the legislature intended that an LLC interest should be treated the same as an LP interest - foreclosure permitted.

 

 

An LLC is More Than a Private Agreement

An LLC is More Than a Private Agreement

      It has been often asserted that a limited liability company is, substantively, simply an agreement among the members (and sometimes the managers) as to the operation of a business which is functionally defined exclusively by that private agreement.  The persons taking this view, while typically recognizing that a state filing is necessary in order to cause an LLC to come into existence, have minimize the importance of this filing, affording it only “ministerial” importance.  A recent decision of the Delaware Chancery Court In re Carlisle Etcetera LLC., has questioned that frame of reference.

      The aspect of the decision hereunder consideration arose out of the Court’s assessment of whether or not it had any power in equity, as contrasted with under the controlling LLC Act, to award judicial dissolution of the company.  It was clear that the party moving for judicial dissolution, not having been admitted as a member, but being a mere assignee of a membership interest, did not have standing to move for judicial dissolution under the act, that capacity being limited to members and managers of the LLC. See Del. Code Ann. tit. 6, § 18-802.  But from that determination the Court considered whether it could, under its equity jurisdiction, consider dissolution of the LLC.

      Looking back to the historic law of partnerships, and referencing the venerable Joseph Story, Commentaries on Equity Jurisprudence, it was observed that courts could in equity dissolve partnerships and as well appoint receivers.  If § 18-802 were the exclusive means of bringing about the judicial dissolution of an LLC, “it would have to divest this court of a significant aspect of its traditional equitable jurisdiction.”  2015 WL 1947027, *8.  From there the Carlisle Court observed that § 18-802 neither states that it is exclusive nor that it overrides equitable jurisdiction, and thus the rules of equity are otherwise incorporated in the LLC Act.  See Del. Code Ann. tit. 6, § 18-1104.

      Looking perhaps to future challenges to equitable jurisdiction even as the conclusion in this case is back stepped, it was observed that efforts by the legislature to limit the Chancery Court’s equity jurisdiction would raise constitutional problems.

      Moving from the Court’s equitable powers, it next considered the question of “what is an LLC?”  After noting that under R & R Capital, LLC v. Buck & Doe Run Valley Farms, LLC, 2008 WL 3846318 (Del. Ch. Aug. 19, 2008), the parties to an operating agreement may waive the right to move for statutory judicial dissolution, “In my view, the ability to waive dissolution under Section 18-802 does not extend to a party’s standing to seek dissolution in equity.”  2015 WL 1947027, *10.  From thus the Court wrote:

In concluding that parties to an LLC agreement could waive the right to seek dissolution under Section 18-802 the R & R Capital decision relied heavily on arguments by commentators to the effect that a Delaware LLC should be viewed as a purely contractual entity to which principles of equity (including fiduciary duties) do not apply.  Reasonable minds could disagree about that proposition.  But whatever one’s personal thoughts might have been on the matter, the General Assembly in 2013 adopted an amendment to the LLC Act inconsistent with the purely contractarian view.

Of particular relevance to dissolution the purely contractarian view discounts core attributes of the LLC that only the sovereign can authorize, such as its separate legal existence, potentially perpetual life, and limited liability for its members.  See 6 Del. C. §§ 18-201, 18-303.  To my mind, when a sovereign makes available an entity with attributes that contracting parties cannot grant themselves by agreement, the entity is not purely contractual.  Because the entity has taken advantage of benefits that the sovereign has provided, the sovereign retains an interest in that entity.  That interest in turn calls for preserving the ability of the sovereign’s courts to oversee and, if necessary, dissolve the entity.  Put more directly, an LLC agreement is not an exclusively private contract among its members precisely because the LLC has powers that only the State of Delaware can confer.  Those powers affect the rights of third parties, who at a minimum must take into account the LLC’s separate legal existence and its members’ limited liability shield.  Just as LLCs are not purely private entities, dissolution is not a purely private affair.  It involves third party claims, which have priority in the dissolution process.  See id. §§ 18803, 18-804 (describing winding up and priorities for distribution of assets).  Because an LLC takes advantage of benefits that the State of Delaware provides, and because dissolution is not an exclusively private matter, the State of Delaware retains an interest in having the Court of Chancery available, when equity demands, to hear a petition to dissolve an LLC.

Id. at *11 (citations omitted).

      An LLC is more than a private agreement, and the state has a legitimate interest in policing its activities at least as necessary to protect third parties.

     Other aspects of the In re Carlisle Etcetera LLC decision have been reviewed HERE.

Delaware Chancery Court addresses important decision including requirements foradmission of assignee as a member, standing to bring an action for judicial dissolution and availability of equitable dissolution

Delaware Chancery Court addresses important decision including requirements for admission of assignee as a member, standing to bring an action for judicial dissolution and availability of equitable dissolution

     In a recent decision, Delaware's Chancery Court addressed a variety of important issues regarding limited liability companies and as well the equitable jurisdiction of the Chancery Court. With respect to LLCs, the Court explained the requirements for admission of an assignee as a member, holding that it requires a formal affirmative act. In addition, the Court affirmed the statutory rule that standing to bring an action for judicial dissolution is restricted to a member or manager, and an assignee is neither. Still, the underlying complaint was not dismissed as the court found that the assignee may have standing to seek equitable dissolution. In re Carlisle Etcetera. LLC, C.A. No. 10280-VCL, 2015 WL 1947027 (April 30, 2015).

      Carlisle Etcetera, LLC (the “Company” or “Carlisle”) was formed and owned equally by Well Union Capital Limited (“WU Parent”) and Tom James Company (“James”). The Company was in turn managed by a four member board, half of whose members were appointed by WU Parent and half by James. In addition, the Company had an executive staff including a CEO, which position was filled by a James executive appointed by that Board. The relationship between WU Parent and James ultimately soured, and despite some initial negotiations they were unable to agree to a price by which one side would buy out the other. With the board deadlocked, the Company CEO operated the Company essentially free of any oversight. In consequence, “James did not see the deadlock as a problem and [felt] no urgency to alleviate it.” Also, on a date not defined in the opinion vis-à-vis the organization of the company, but clearly early on, WU Parent assigned its interest in Carlisle to a “wholly-owned subsidiary that would act as a ‘blocker’ entity for tax purposes.” There was no dispute that the James representatives in Carlisle were aware of this transfer; whether they had consented to the substitution of the new WU Subsidiary (“WU Sub”) as replacement member would be an important aspect of this decision.

      Unable to agree as to a buyout of one party by the other, WU Sub filed an action in the Delaware Chancery Court seeking the judicial dissolution of the Company. When James challenged the capacity of WU Sub to bring an action for judicial dissolution, asserting it was not a member, a WU Parent joined in the action. As is detailed below, that did not cure the deficiency.

      This opinion was rendered in response to the James’ 12(b)(6) motion.

Standing to Seek Judicial Dissolution

      James asserted that neither of the WU entities had standing to seek judicial dissolution on the basis that judicial dissolution is a right afforded the members, and neither was a member. In furtherance thereof, while WU Parent may have initially been a member of the Company, it transferred its entire membership interest in the Company to the WU Sub. While that constituted WU Sub as a assignee of the interest, that assignment also terminated WU Parent’s position as a member. In that WU Sub was never admitted as a substitute member, it could not exercise any rights of a member. Essentially, James asserted that it and it alone was a continuing member in Carlisle. On this argument it would prevail.

      Under the Delaware LLC Act, when a member assigns all of their economic interest in a venture, the assignor member ceases to be a member in the company. See Del. Code Ann. § 702(b)(3). [It should be noted that this rule under the Delaware LLC Act is different than the rule under the Kentucky LLC Act.] In the face thereof, WU Sub argued that James had consented to its admission as a substitute member, arguing for de facto status based upon it being listed in the Carlisle tax forms and as well the identification of WU Sub as a member in the draft revised (but never executed) operating agreement. “WU Sub argues that it became a member under the LLC Act once his status as a member was “reflected in the records of the limited liability company.”, citing Del. Code Ann. § 18-301 (b)(1).

      Carefully parsing the statute, the Court found that was not the case. Rather, while the timing of admissions as a member may be determined by when a member’s admission is “reflected in the records of the limited liability company,”, that reflection does not of itself constitute admission. Rather, a formal act of the other members to the admission is required.

      Hence, WU Sub was not a member and could not move for judicial dissolution.

Equitable Dissolution

      Notwithstanding that neither WU Sub nor WU Parent had capacity to move for judicial dissolution of Carlisle, LLC, the Chancery Court consider whether they could do so on an equitable basis. In consideration thereof, the Court provided several pages of analysis as to how the equitable jurisdiction of the Chancery Court could be employed and when that jurisdiction is limited consequent to the existence of a comprehensive legal regimen. Based upon the facts presented, the Court determined that WU Sub, as the holder of equity in Carlisle even as it is not a formal record owner, may seek equitable dissolution of the Company.

     A few thoughts:

·         Notwithstanding the asserted certainty of Delaware law, decisions such as this highlight the fact that Delaware law is often fact specific (as is the right of a Court of Equity) and is far more fluid than many people would think. In this instance, the statute affords a member the right to seek judicial dissolution. A nonmember, who cannot seek judicial dissolution, is still allowed to move for equitable dissolution.

·         One basis cited in support of the Court's determination that equity should intervene and possibly allow dissolution is that the parties had negotiated, but never executed, an amended operating agreement which would have substituted WU Sub as a member who, inter alia, would then have had the capacity to move for judicial dissolution. If courts are going to allow such reliance, parties negotiating amended agreements need to take great care to legend their discussions so as to not give rise, based upon preliminary documents, to new rights.

Kentucky Supreme Court Finds No Agreement to Arbitrate Disputes; Document Architecture Matters

Kentucky Supreme Court Finds No Agreement to Arbitrate Disputes;
Document Architecture Matters

      In a decision rendered last month, the Kentucky Supreme Court held that students enrolling at Daymar College did not agree to arbitrate their disputes with the college.  In part this decision was based on the curious architecture of the agreement at issue.  Dixon v. Daymar College Group, LLC, __ S.W.3d ___, 2012-SC-000687-DG, 2015 WL 1544450 (Ky. April 2, 2015).

      Certain students brought action against Daymar based on allegations of fraud in the enrollment process, breach of contract, etc.  They also sought class action status.  Daymar sought to refer the complaints to arbitration.  In opposition to their efforts the students asserted, inter alia, that there was no agreement to arbitrate. 

      Students enrolling at Daymar completed a variety of forms.  One of those forms contained, on its reverse side, an “agreement” to arbitrate all disputes.  The signature block appeared, however, on the front of the document, and it never provided above the signature that the language on the reverse was incorporated by reference. 

      The trial court denied arbitration.  On appeal, the Court of Appeals reversed that decision.  That ruling is reviewed HERE IS A LINK.  The Supreme Court would reverse the Court of Appeals and affirm the decision of the trial court.  Ergo, no enforceable agreement to arbitrate.

      Kentucky has a statute, KRS § 446.060, which provides that the signature of a party to an agreement must appear at or near the end of the agreement, a requirement applicable only to agreements which must be in a signed writing.  While an agreement to arbitrate need not be in a signed writing, the programs for which the students enrolled all exceeded a year in length.  As such the enrollment documents needed to satisfy the Statute of Frauds (KRS § 371.010(7)).  From there KRS § 446.060 was applicable, and the agreement to arbitrate on the reverse of the signed document would be effective only if it was incorporated by reference above the signature block.  The Supreme Court found there to be no such incorporation.  Further, each student’s acknowledgement that they had read the reverse could not be extended into an agreement to be bound by the terms set forth on the reverse.

Limited Liability Companies in Kentucky - Chapter Supplements

Limited Liability Companies in Kentucky

 

I have prepared and made available cumulative supplements to the following chapters of the UK/CLE treatise Limited Liability Companies in Kentucky:

 

Chapter 5        Basics of LLC Formation

Chapter 6        Foreign LLCs

Chapter 8        Statutory Transactions: Conversions, Mergers and Share Exchanges

Chapter 9        Dissolution of a Limited Liability Company

 

There has also been added a new chapter 9A, Developments on the Law of Kentucky LLCs. 

 

They can all be accessed through THIS LINK.

It’s Deja Vu All Over Again

It’s Deja Vu All Over Again

 

            In Pannell v. Shannon, 425 S.W.3d 58 at 79, 80; 2014 WL 1101472, *7 (Ky. March 20, 2014), the Kentucky Supreme Court wrote:

 

In fact, “limited liability companies are creatures of statute,” controlled by Kentucky Revised Statutes (KRS) Chapter 275, not primarily by the common law. To the extent that common law doctrines could arguably govern limited liability companies, the Kentucky Limited Liability Company Act “is in derogation of common law,” KRS 275.003(1), and the traditional rule of statutory construction that “require[s] strict construction of statutes which are in derogation of common law shall not apply to its provisions.” Thus, to the extent the statutes conflict with common law, the common law is displaced.

 

This Court must therefore first look at the controlling statutory law. (citations omitted).

 

In The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Arkansas Law Review 473 at 501-02 (2010), Professor Thomas Earl Geu and I observed:

 

Moreover, and as a matter of interpretive policy, the law of business associations seems to have become more “statutory” over time in ways other than through the invention or recognition of “new” entities.  Even the fiduciary provisions within states like Delaware are the subject of great statutory detail. Professor Langbein has explored this same trend toward statutes in trust law, suggesting several reasons for the “statutorification” of trust law including speed, comprehensiveness, and the ability to bring specific expertise to bear in increasingly complicated and interrelated topical areas of law. It seems those reasons could also help explain the general trend of the increase in statutory business association law.  If this supposition is correct, courts should exercise great care when analyzing or generalizing from one statute to another where the different statutory schemes vary in manner of expression, detail of regulatory method, and scope of application. (citations omitted).

Let’s Stop Describing LLC’s as “Hybrids”

Let’s Stop Describing LLC’s as “Hybrids”

      Recently I published in the Journal of Passthrough Entities Let’s Stop Describing LLC’s as “Hybrids”. 

      In this article I challenge the often made suggestion that LLC’s are a hybrid of corporate and partnership law, a statement which is then typically followed by an effort to pigeonhole the particular question into the answer that would result from either partnership or corporate law. I suggest that the LLC needs to be considered as a unique organizational form not derived from either partnership or corporate law.  

      The article can be accessed through HERE IS A LINK TO THE ARTICLE.

Pannell v. Shannon – A Cornicopia of Guidance on Contract Law, Statutory Interpretation and the Place of LLCs in the Law

Pannell v. Shannon – A Cornicopia of Guidance on Contract
Law, Statutory Interpretation and the Place of LLCs in the Law

      The Kentucky Supreme Court’s decision in Pannell v. Shannon is of great utility on a variety of fronts including identifying a test for when an agreement is executed by an agent versus by a principal, the effect of administrative dissolution/reinstatement upon an agent’s liability, rules for interpreting statutory amendments, and the importance on focusing upon the LLC Act over the common law in assessing LLCs.  Pannell v. Shannon, 425 S.W.3d 58 (Ky. March 20, 2014).

      The dispute arose out of a defaulted lease.  Shannon’s LLC was the tenant – that LLC was during the term of the lease administratively dissolved.  A replacement lease was entered into in the period between the administrative dissolution and the LLC’s reinstatement.  When the LLC ultimately defaulted the landlord sought to hold Shannon liable on the obligation.

Was the Lease with Shannon or the LLC?

      The lease agreement entered into during the period of the LLC’s administrative dissolution described the tenant as being the LLC, but the signature line did not specify that Shannon signed it in a representational capacity (e.g., “Ann Shannon, Sole Member, on behalf of Elegant Interiors, LLC”).  The Court held that level of specificity to not be necessary.  Rather, noting that it indicated “By:” and in reliance upon Fletchers Cyceopedia, the Court found this format, combined with the fact that the body of the lease identified the LLC as the tenant, to be sufficient to indicate she was not signing in an individual capacity.

[T]he simple fact is that Shannon did not have to list her title, although clearly the better practice is to include it.  425 S.W.3d at 64.

Scrivener Error?

      Pannell sought to argue that the identification of the LLC as the tenant was a “scrivener error” and that it was always intended that Shannon as an individual be the tenant.  This argument was rejected on the basis that “full, clear, and decisive evidence” of a mutual mistake was not presented.  425 S.W.3d at 67.

The Effect of Administrative Dissolution/Reinstatement

      The real crux of the decision is the impact of administrative dissolution and subsequent reinstatement upon each of (i) a member’s limited liability and (ii) the liability of an agent on a contract entered into after dissolution and before reinstatement.  425 S.W.3d at 68.  The Court recognized that these are distinct questions based upon distinct legal principles:

“[T]he liability of a director, officer, employee or agent of a limited liability entity during a period of administrative dissolution is technically a separate question from the liability of the owners of the entity.”  425 S.W.3d at 77.  

Member Limited Liability After Administrative Dissolution

      The Court could not have been more express about the continuity of a member’s limited liability after reinstatement:

This Court concludes that a member of an [LLC] enjoys statutory immunity from liability under KRS 275.150 for actions taken during a period of administrative dissolution so long as the company is reinstated before a final judgment is rendered against the member.  425 S.W.3d at 67.

      Distancing LLCs from the common law of corporations (more on that below), the Court looked to the statutes addressing a member’s limited liability (KRS § 275.150) and the retroactive effect of reinstatement (KRS § 275.295(3)(c); now KRS § 14A.7-030(3)) and determined that reinstatement wiped the slate clean.

The plain meaning of the relate-back language is that the company is deemed viable on reinstatement from the point of administrative dissolution onward, which necessarily includes the time of suspension between the date of administrative dissolution and reinstatement.

Reinstatement under the statute literally undoes the dissolution. This is why the Secretary of State was required to “cancel” the certificate of dissolution and issue a certificate of existence. See KRS 275.295(3)(a). And that certificate of existence took effect, by statute, retroactively on the date of dissolution.  425 S.W.3d at 68.

Hence Pannell’s argument that a member’s limited liability is suspended during the period between administrative dissolution and reinstatement was rejected.

Agent Limited Liability After Administrative Dissolution

      Turning to the question of Shannon’s liability as an agent for the LLC’s obligation undertaken while the LLC was administratively dissolved, the Court noted that the question divides into a pair of inquiries, namely:

First, can Shannon under the circumstances of this case be personally liable by reason of her merely being an agent?  Second, can she be personally liable because she acted as an agent without authority?

       In response to the first question, the Court referred to KRS § 275.175(1) and noted that its rule of limited liability extends to the LLC’s agent.  As the LLC’s existence had been reinstated and:

reinstatement is retroactive to the date of dissolution, and it is as if the dissolution never occurred, giving the company a seamless existence.  The limitation on the agent’s liability simply for being an agent is likewise seamless.  425 S.W.3d at 78.

      In that the LLC in question was subsequently reinstated, the Court found there to be no opportunity for imposing liability on an agent.  Rather, as the LLC Act protects agents from liability on the LLC’s debts (KRS § 275.150(1)), then: 

To the extent that any liability is claimed solely because Shannon was a manager or agent of the LLC, the analysis above for why she cannot be liable as a member applies.  The reinstatement is retroactive to the date of dissolution, and it is as if the dissolution never occurred, giving the company a seamless existence.  The limitation on the agent’s liability simply for being an agent is likewise seamless.  425 S.W.3d at 78. 

     Providing an appropriate critical eye to the question before it, the Court observed:

The immunity provided by KRS 275.150 extends only to liability by reason of her being an agent.  By alleging that Shannon acted without authority, Pannell is not claiming she is liable solely because of her status as an agent, but because she had no authority to act as an agent.  425 S.W.3d at 81. 

In reliance upon the statutory statement that a dissolved LLC continues to exist after its dissolution, the Court found that when combined with reinstatement, Shannon never lost the capacity of being the LLC’s agent.

In response to the argument that giving such a broad affect to the effect of reinstatement is improper, the Court observed:

The simple fact is that Kentucky’s corporation law and other business entity laws differ from those in other states ….  The existence of a majority rule can only be persuasive if the rule is based on statutes like those in Kentucky.  425 S.W.3d at 79, 80.

The Nature of LLCs

No end of confusion has resulted from efforts to force LLCs into the prior models of partnerships and LLCs and to them impose the supposed common law of these organizational forms onto the LLC.  The first decision of the Kentucky Court of Appeals in Patmon v. Hobbs, 280 S.W.3d 589 (Ky. App. 2009) is a classic example of a court trying to do so.  Why that does not work was been extensively reviewed.  See, e.g., Rutledge and Geu, The Analytic Protocol for the Duty of Loyalty Under the Prototype LLC Act, 63 Arkansas Law Review 473 (2010). 

      In Pannell, the Supreme Court, building upon prior decisions, made the rule express – LLCs are creatures of statute divorced from the common law.

[The] common law of business entities has largely been abrogated by the adoption of the various statutes like the Kentucky Business Corporation Act and the Kentucky Limited Liability Company Act.  In fact, “limited liability companies are creatures of statute controlled by Kentucky Revised Statutes (KRS) Chapter 275,” not primarily by the common law. To the extent that common law doctrines could arguably govern limited liability companies, the Kentucky Limited Liability Company Act “is in derogation of common law,” KRS 275.003(1), and the traditional rule of statutory construction that “require[s] strict construction of statutes which are in derogation of common law shall not apply to its provisions.” Id. Thus, to the extent the statutes conflict with common law, the common law is displaced.

This Court must therefore first look at the controlling statutory law.  425 S.W.3d at 67-68.  (citations omitted).

      Consequently, in assessing matters involving LLCs the court needs to focus upon the LLC Act and the operating agreement of that particular LLC.  Whether, for example, LLC members are more like partners or more like shareholders is irrelevant to the question of whether the members have fiduciary duties and what those duties are – the LLC Act expressly addresses whether the members owe fiduciary duties, what those duties are and to whom they are owed.  See KRS §§ 275.170(1), (2), (4).  At the risk of redundancy:

[F]irst look to the controlling statutory law.

Continuity in Statutory Construction

      The Kentucky LLC Act provides that a LLC’s dissolution will not “abate or suspend” the rule of limited liability set forth in KRS § 275.150.  KRS § 275.300(4)(e).  Accord KRS § 271B.14-050(2)(i).  While this statute was adopted only in 2007, the Kentucky Supreme Court found this provision was not an alteration of the law but rather “clarified the intent of the legislature as to the effect of dissolution on the liability of … corporate shareholders.”  425 S.W.3d at 72.  This application of in pari mataria, which requires a nuanced consideration as to whether the General Assembly sought to alter versus clarify the meaning of a prior enactment, stands in contrast to the far more clumsy, and typically inapplicable, rule to the effect that by each amendment the legislature seeks to alter and depart from the prior rule.  In the area of business entity law, based as it is upon typically comprehensive statutory schemes, tweaking the words employed for the purposes of providing greater clarity and precision is far more typical than is a reversal or abandonment of a principle.  That is not to say it never happens, but it is relatively rare.

Subsequent Statutes Address Liability Absent Reinstatement

      While Pannell v. Shannon limits its application to the treatment of member and agent liability after there has been reinstatement, it does not follow that member and agent liability absent reinstatement remains unresolved.  Rather, questions of member limited liability have been addressed in statutory amendments enacted subsequent to the time the Pannell v. Shannon dispute arose. 

      First, KRS § 275.300, it addressing the effects of dissolution, now provides that dissolution does not “abate or suspend” the rule of limited liability.  In consequence, it cannot be argued that a member’s/manager’s/agent’s limited liability is lost upon dissolution.  In this respect it is important to note an important distinction between the corporate and LLC Acts.  The Business Corporation Act, at KRS § 271B.6-220, affords the shareholders limited liability from the corporation’s debts and obligations.  Hence, KRS § 271B.14-050(2)(i), in preserving limited liability upon dissolution, preserves it only for the shareholders.  Put another way, KRS § 271B.14-050(2)(i) does not speak to the liability of corporate directors, officer and agents for a corporate liability undertaken post-dissolution and absent reinstatement.  In contrast, the grant of limited liability in the LLC Act, KRS § 275.150(1), applies not only to members but also managers and agents.  Hence the preservation of limited liability after dissolution as affected by KRS § 275.300(4)(e) is broader than is the equivalent provision in the Business Corporation Act.  Now, whether after dissolution and before reinstatement one was an “agent” may be in dispute, but that is resolved under other law.

      Second, it has been made express that upon reinstatement following administrative dissolution, the liability of an agent for actions undertaken during the period of dissolution “shall be determined as of the administrative dissolution or revocation had never occurred.”  KRS § 14A.7-030(3)(b).  See also 425 S.W.3d at 81, note 20.

      Third and last, in response to Martin v. Pack, the acts now provide that an agent may after dissolution enter into contracts appropriate for the entity’s winding up and liquidation.  See KRS § 275.300(2)(a); id. § 271B.14-050(1)(c).

More on Member Limited Liability

      Building upon the earlier decision in Racing Investment Fund 2000, LLC, the Court highlighted the centrality of limited liability to the LLC and imposed a high bar for setting it aside.  425 S.W.3d at 66.  As such, where it is questionable whether an agent enjoys limited liability, the presumption will be that it is available.  It remains to be seen whether and how this attitude will impact upon whether and how is developed a distinct theory for piercing LLCs.

More on the Nature of Administrative Dissolution

      In Pannell, the Kentucky Supreme Court considered the purpose of administrative dissolution and rejected an effort by a third-party to impose liability upon a dissolved LLC’s agent for an LLC obligation based upon “the temporary faltering of the relationship between the LLC and the state to [the third-parties’] advantage when [the third-party] has no interest in that relationship.”  425 S.W.3d at 84.  Administration dissolution to be little more than a speed-bump in the bilateral relationship between the Commonwealth and an entity created under the laws thereof.

More on the Source of Duties in LLCs

      The Supreme Court has directed that the first source of LLC law is the LLC Act and recognized that LLCs are strangers to the common law.  In Patmon v. Hobbs, the Court of Appeals imposed fiduciary obligations upon the “officers and members” of an LLC based upon the determination that LLCs are “similar to Kentucky partnerships and corporations.” 280 S.W.3d at 594-95.  The Pannell decision significantly undercuts (if not more) this analytic path, and directs that rather than relying upon analogy to other organizational forms the focus needs to be upon the language of the LLC Act.  In that the LLC Act defines who owes fiduciary duties, to whom they are owed and what are those duties (KRS § 275.170), there the question should end.

A Small Footfault on Member – versus – Manager-Managed

      It bears noting that the Court made a small misstep in its consideration of agency and the application of KRS § 275.135.  This statute provides, inter alia, that in a member-managed LLC each member as a member is an agent of the LLC while if the LLC is manager-managed the managers are agents and the members are not by reason of that status agents.  The Court suggested that the determination of whether the LLC is member or manager managed is determined by a factual assessment of the management employed.  See 425 S.W.3d at 76, fn. 17.  In fact, whether an LLC is member or managed is a positive law question determined by reference to the election made in the articles of organization.  See also KRS § 275.025(1)(d).  As set forth in the comment to Prototype section 401, “Irrespective of the provisions in the operating agreement, whether a LLC is ‘manager managed,’ as that phrase is used in the Act, depends on whether the articles of organization so provide.”